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Did Shell Take On Too Much Risk In This Oil Price Environment?

On the heels of its acquisition of BG Group at a time when everyone else is offloading assets in these days of dismal oil prices, Royal Dutch Shell is banking optimistically on $50 oil to make this work, and hoping that a much leaner BG will do the trick.

The $50 billion acquisition is a risky prospect indeed, even though Shell is adamant that after dumping assets and jobs, the acquisition will actually turn a profit at $50 per barrel of crude. According to Shell, this is the worst-case, short-term scenario.

Despite plenty of sentiments to the contrary, Shell is fervently lobbying for this deal to go through. Last week, an influential shareholder advisory group—Institutional Shareholder Services—even recommended that investors embrace the BG takeover, according to the Wall Street Journal. They cited “credible evidence” that Shell was paying a fair price, even in the current oil price slump.

There are, however, two outstanding questions that could make or break the success of this deal. 1) Will Shell find any buyers for these assets at this lean time when most prudent players aren’t looking to buy? and 2) Will prices reach $50 per barrel in the near term—or even in the medium term? Related: Saudi Arabia: A Weak Kingdom On Its Knees?

A recent Reuters poll of analysts put the average price for crude at $52.52 for 2016. A number of other organizations have begged to differ. Last fall, Goldman Sachs played the first harbinger of gloomy times to come, alerting investors that oil prices could fall as low as $20 a barrel. Although this looked unlikely at the time, the $20-a-barrel scenario has been looking increasingly realistic as of late. Earlier this week, in fact, oil fell below $30 a barrel briefly for the first time in 12 years. And last Friday, Brent oil even touched the $28 handle.

The price slide has been relentless. Still, Shell soldiers on.

The International Monetary Fund (IMF) and the International Energy Agency (IEA) share Goldman Sachs’ pessimism. The IMF predicts that after Iran rejoins the global oil market, prices could drop to $20-$30 per barrel, while the IEA warns that demand for oil continues to lag significantly behind supply, and that this will continue through 2016. Related: Forget $20 - Oil Prices At $8 Per Barrel In Canada

A few optimistic voices disagree, but this optimism does little to alter the fundamentals: Brent crude closed at $31.08 on Monday, and West Texas Intermediate settled at $30.94—again, slipping below $30 on Tuesday and Wednesday.

That’s a far cry from the $50 a barrel that Shell is hoping for, and close to that $20-per-barrel that no one thought possible just a few months ago. Whatever the optimists say, there is nothing right now that even hints at a possible improvement in oil prices—which Shell relies on as their income comes mainly from E&P.

So, could Shell be teetering on the brink of the unthinkable? The company may be solid enough to weather the effects of a short-term price slump, but it cannot continue weathering them forever. It prudently kept its refining operations, which are now helping it to stay afloat, but it has been hit harder than its peers. Related: Saudi Aramco IPO More About Geopolitics Than Finance

This isn’t the only recent move by Shell that is disconcerting. It also dropped its Arctic exploration plans after pouring $7 billion into the project.

In its latest financial statement for Q3 2015, Shell reported a net loss of $7.4 billion, but it remained in the black for the first 9 months of the year with a profit of $1 billion. The price tag for the BG Group acquisition is $51 billion, with plans to sell $30 billion worth of assets once the deal is sealed, and cut 2,800 jobs, a figure that’s a noteworthy percentage of BG’s existing 5,200 employees.

What Shell needs is the miracle of rebounding prices—specifically, $50 per barrel within the next couple of years. If no such miracle is forthcoming, the BG Group acquisition could prove to be a fatal blow—bigger and much more ominous than the backlash of the Arctic exploration project. Shell won’t hear it, though, and despite all, it’s BG or bust.

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